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Thursday, November 12, 2009

Leisure Suit Lawsuit

Ben Graham noted that stocks of companies with some lingering uncertainties tend to have their valuations over-punished by the stock market. A pending lawsuit is one such example of a "lingering uncertainty". For this reason, many companies would rather settle legal claims that cast a shadow over the company's valuation even if they think they can win them. However, in such uncertain situations, no liability is recognized on the balance sheet. Nevertheless, investors who take the time and effort to read the legal proceedings that the company discloses put themselves in a position to reduce - or even eliminate - the financial uncertainties.

Consider Adams Golf (ADGF), a designer and distributor of golf clubs. Two days ago, the company reported the settlement of an old claim; the company will be out $5 million as a result. For a company with a market cap of just $19 million, this is a material cash outflow. But for investors, this should come as no surprise. A careful reading of the company's previous notes to its financial statements would have revealed, among other things, the following:

1) The company was insured for exactly this type of infraction for up to $50 million

2) One of the insurers, which was to cover $5 million of the $50 million, claimed a breach of contract and was unwilling to pay

When we previously discussed this stock as a potential value investment two months ago, an astute commenter raised the subject of this lawsuit. The answer a few comments later was that in all likelihood the lawsuit would cost the company $5 million. As such, the company's disclosure two days ago that it would take a $5 million charge to settle this lawsuit came as no surprise. By factoring in this cost before it was even recognized by the company, a more educated decision could be made by the investor as to whether the company was indeed undervalued.

Of course, surprises are still going to occur. Not every event, legal or otherwise, can be foreseen. But by doing their research (by reading the company's disclosures and its notes to the financial statements), investors can minimize risk and reduce uncertainty. In doing so, they can improve their accuracy in determining a company's value.